Universal life insurance has both advantages and disadvantages. We cover both the pros and cons to help you decide whether universal life is best for you.
Every once in awhile, I will receive financial questions from readers. Now, I am not a financial adviser. I usually suggest those needing significant assistance with their financial decisions to seek the advice of a professional. However, I don’t mind answering general questions that might be helpful for a wider audience. I also solicit help from the site’s other writers who may have more knowledge than I on a particular subject.
Today’s question focuses on a topic that I don’t usually cover: life insurance. Specifically, they wanted to talk about universal life insurance, which is a bit of a controversial topic in personal finance circles.
Here’s the question a reader sent in:
I recently read a book called Tax-Free Retirement by Patrick Kelly. In it, the author was selling the idea of buying Universal Life Insurance as a way to build your retirement fund. I’ve been doing research on Universal Life Insurance (pros and cons). What are your thoughts on Universal Life Insurance, and is it something you recommend people buy?
What is Life Insurance?
Let’s take a moment to talk about the many aspects of life insurance in general. Then, I will circle back to address the specific question about universal policies and retirement funds.
So, there are three primary parties when it comes to insurance: the insured, the beneficiaries, and the insurer. Life insurance policies are offered by the insurer to protect the income and earning potential of the insured.
If the insured passes away, the beneficiaries — who relied on the income of the insured to some degree — can continue with a comparable quality of life. This may be in the form of receiving regular income (through a trust) or even getting a lump sum payment.
For example, the head of a household (or all income earners in a family) may buy life insurance in order to protect the needs of their children. This coverage could ensure that the children have their everyday needs met, as well as provide for future education expenses, healthcare, and the like.
Life insurance benefits could also help pay for funeral costs, medical bills, and any outstanding debts (such as a mortgage or joint credit card debts) that the insured may leave behind.
Types of Life Insurance
Term Life Insurance
Life insurance comes in several flavors. The most common, and the most basic, is term life insurance.
This is a typical insurance policy, where coverage is based on a set number of years. During that period, the insured will pay premiums and be protected. However, at the end of the term, the protection ends.
While term life insurance gives you the most bang for your buck, the nature of it means that someone could essentially pay into a policy for several decades without a return. If that insured individual continues to live and stay healthy, he or she will never receive any benefit from their term policy, other than peace of mind.
At the end of a policy term, insurers typically offer an option to renew the policy. However, depending on your age and any health changes, your premiums are likely to go up with renewal. This is why term life insurance is more ideal for younger, healthier adults, when their risk of death is lower.
Related: How Much Life Insurance Do You Need?
Of course, the idea of paying into a policy for years without receiving any benefit didn’t sit well with many. So, insurers eventually came up with different types of policies.
Permanent Life Insurance
These alternatives are often called permanent life insurance policies, and there are several different plans designed to suit a customer’s needs. Universal life insurance is one form of permanent life insurance. Whole life insurance is another.
These non-term policies usually include a savings or investment component in order to help insurers mitigate some risk. That’s because, in these permanent policy scenarios, the chance of paying out benefits is closer to 100 percent. This component can make them a very tempting choice when shopping for life insurance, but let’s take a deeper look before you make any decisions.
What Is Universal Life Insurance?
Universal life insurance is a type of permanent policy that can provide coverage for the remainder of your life. You won’t have to worry about renewing the policy every five, 10, or 20 years, as with term insurance. However, if you want to cancel at any time, you’ll actually have the opportunity to cash out on some of the money that you paid into the policy.
These policies often cost considerably more than term policies of the same coverage amount, but provide some flexibility in the premium payments over time.
Premiums, in case you don’t know, are the amount of money that the insured pays to the insurer for the coverage, usually on a monthly basis. The unique thing about permanent life coverage, though, is that a portion of these monthly payments also goes toward funding each policy’s savings component.
The savings component is the cash value portion of the insurance policy. It’s basically a savings account from which the insured can withdraw or borrow money over time. They can even use it to reduce or skip their policy premiums when needed. The younger and healthier you are, the more money is placed in this account; as you age or as your health deteriorates, a smaller percentage of your monthly premium will go toward building this cash value.
Because of this benefit, the premiums are much higher. Sometimes, the difference in premium is a factor of ten. So, is the savings portion worth ten times more than a basic insurance policy on its own?
The Pros of Universal Policies
There are a number of reasons that universal life insurance policies are so appealing.
First off is that whole savings component. At its foundation, it’s much more ideal to buy life insurance that actually holds some value. If you decide you don’t want the policy 15 years from now, you’ll simply* be able to cash out.
*I say simply, but the ease of this policy cancellation varies. We’ll discuss this in the cons section, next.
You also have a potential nest egg built up after all of those years, which could be seen as a forced retirement savings vehicle (if you’re the type of person who needs that sort of thing).
You’ve been paying premiums and your money has been earning interest for years. If you live to a ripe old age, you have a nice chunk of change saved up, which you can either leave alone or borrow from when needed. If you don’t, your beneficiaries receive their payout, without you having to worry about renewing term policies over the years.
Another interesting benefit of universal life insurance is that the insured can use interest earned on the savings component to help pay the monthly premiums. If you get in a financial bind or want to allocate your money elsewhere for a few months, you usually can (depending on the cash value and interest earned on your policy).
One of the biggest perks of a permanent policy, though, is simply avoiding the issue of renewing term policies or shopping around for rates every few years. You can stick with one policy throughout the decades, and have one less thing to worry about. This is particularly great if you already know that you’ll need lifelong coverage in order to provide for a dependent, such as if you have a special needs child or a disabled spouse.
There are quite a few downsides, though.
The Cons of Universal Life Insurance
High Fees
While the savings component of a universal policy sounds great in theory, it may not be so wonderful.
Compared to the returns earned by your universal policy premiums, you may be shortchanging yourself. You may easily be able to generate your own returns in savings or investments that are significantly better than the returns you’d receive through your policy. You’ll also have much more flexibility with your own investments and can make your own decisions. You don’t have any say where your policy’s cash value savings are invested.
To further that note, you’ll also likely pay much higher fees for managing the investments of your universal life insurance policy. With other retirement accounts, such as 401Ks, you can find investment fees as low as half a percent or lower. Universal life policies, however, often have fees as high as 3%. This can make a significant difference in the overall growth of the savings.
Cancellation Fees
Another downside is that when you withdraw or borrow money from a universal life insurance policy, it reduces the amount that your beneficiaries would receive if you died before repaying the loan. This alone is often enough to steer people away from this type of coverage.
If you buy into a policy and then change your mind later, you can cancel. However, cancellation isn’t easy, and can wind up costing you a pretty penny depending on how long you’ve held the policy. Be sure to read the fine print to see how much of your cash value you will forfeit if you cancel the policy in the first 3 years, 5 years, 10 years, and so on.
Mediocre Returns
Now, to what I consider to be the biggest downside of them all. Remember how we talked about universal policies being for life, versus a shorter “term” length? Well, there’s a very important caveat that could land you in some serious hot water, if you’re not careful.
Yes, universal life insurance policies can last you the rest of your life. However, this depends on the returns of those invested savings and the actual cost of your death benefits, according to your health changes over time.
As mentioned, a portion of your premiums each month goes toward your actual “life insurance coverage.” Let’s say that you’re a 25 year-old in great health paying $100 a month. Twenty dollars of that might be going toward the insurance company’s actual cost for providing life insurance for you. The remaining $80 is going into your cash value savings.
However, as you age, that number will change. When you turn 60, that split might be closer to $70 for benefits and $30 going into savings. When you hit 75, you may be in deteriorating health and those investments might not have panned out as well as the insurance company had hoped; in turn, the company may require more than $100 a month for your coverage, even though that’s your premium amount.
To make up for the deficit, the insurance company can (and will) dip into those cash value savings. If it goes unnoticed, you could realistically check on your account one day — you know, the one you counted on to be your big nest egg and provide life insurance benefits for your family upon your death — only to find it dwindled away to nothing. Decades of savings and “guaranteed” benefits, gone.
Unnecessary for Most
One final note. Most individuals do not need permanent life insurance. A retiree who has little or no earned income, for example, often has no need of life insurance. One exception, however, are families caring for disabled adult children. But again, for most families, life insurance is unnecessary after the kids have left home and retirement is at hand.
Should a Universal Life Policy Build Your Retirement Fund?
This is a tricky decision and has a lot of drawbacks. But the savings component can still make this a tempting option for many.
There are three major drawbacks to this approach that you should keep in mind before buying into a policy. Because of these reasons, I would not use a life insurance policy of any type to increase my planned income during retirement.
- Any retirement income you need and withdraw reduces the value of the benefits your heirs will receive, as mentioned above.
- You can get better investment options by opening an IRA at a discount brokerage.
- You’ll be paying much more for less potential performance than other retirement options. Even a 401(k) could cost much less.
If you’re a savvy saver and investor, you may want to leave your investments separate from your life insurance policy and opt for term life insurance. If you appreciate consolidating your savings with your insurance policy and are not concerned with a significantly higher cost, it might make sense to opt for this type of coverage.
For readers: Do you have a universal life insurance policy and are you happy with the insurer so far? Have you had any experiences collecting benefits from a policy?
Published or updated September 21, 2017.
{ 17 comments… read them below or add one }
If you are already making full use of your 401(k), ROTH 401(k), IRA, ROTH IRA, and have reasonable term life insurance coverage, Universal Life can be a fit for you.
“If you are already making full use of your 401(k), ROTH 401(k), IRA, ROTH IRA, and have reasonable term life insurance coverage…” Go out – have a good time – enjoy life. Unless the agent is a relative or friend you want to support and enrich, you’ll probably just be filling up their desk with little awards and trinkets given out when the bosses are doing really really well. (I said that? – must be Monday)
I agree it is important to go out and enjoy life, but what are you going to do if you develop a health condition which makes you uninsurable once your term life policy has expired and or the market crashes like in 2008 and your qualified retirement value has gone down the drain?
I’ve always heard that universal life policies are a rip off, so I’ve never pursued one. I do have an excellent term life policy that is reasonably priced.
I have found that some Universal life and Whole life policies will accept some people that can’t get Term policies. My wife is actually one. She has a certain medical condition that we can’t find anyone that will give her a term policy on (except State Farm – if she has a State Farm Whole Life policy). Universal life or any other permanent life policy is better than no life insurance policy. I’d say get term life if you can. If you can’t then it might be worth a look as these less desirable life policies.
With no dependents, I’ve opted to forego life insurance. If I’d had kids, I might have gotten a term policy until they were grown. I think we are programmed that you must have life insurance—-but if no one depends on your income, why? For retirement, I prefer a Roth IRA.
Roth IRA is outstanding, but Roth IRA caps your contribution at $4,000/year currently. That’s a meager sum to put away for any retirement plan. I find that Universal Life policies are actually outstanding form of savings for retirement. There is a compound interest component (without any taxation) that really impacts the growth of your cash values, and then allows you to withdraw them during retirement years. It’s best that you speak to a professional life insurance agent who can properly guide you through how to strategically take advantage of one of these policies. I have a Universal Life policy and based on my company’s guaranteed performance, I will retire with an additional $2,000,000. Based on their non-guaranteed performance, I will retire with an additional $3,500,000 (only $850,000 was my contribution). My insurance agent has walked me through how to minimize my taxation on the growth – and in comparison, my life policy completely outperforms my 401k.
Not that it takes away from the point of your comment it is likely you are talking about whole life (possibly variable univ life, but most likely WL).
Very good column flexo. I think the allure of universal life insurance is tempting but if I have to choose between the 2, I would stick with a 20 or 30 year term life insurance policy.
I have a friend who just bought universal life for his newborn baby as a vehicle to save for college. I don’t know much about ULI except for the fact that the fees are ridiculously high. Anyone know the pros and cons of this? He said he wants to do this as opposed to a 529 plan, as his “financial adviser” said this is a better option.
He’s a good friend and pretty open, so I’m not shy about having a talk with him about how much of a mistake this might be.
Ask him again, I bet he actually has a Whole Life rather than a VUL
If the poster was referring to fees as opposed to premiums, then it is more likely that this IS a variable type product. Whether this is variable whole life or variable universal is very secondary. Life insurance policies with cash value are typically some combination of the words [Variable|Fixed(or Indexed)] + [Universal|Whole].
Great post on Universal Life Insurance. A few things I would like to add. If you are planning on using these policies as any sort of investment, you absolutely have to over fund them.
They are generally designed to have you pay the minimum premium to carry the policy out to age 120. The cash value you see in the middle years are really meant to contribute to your premiums at your older ages. That being said, if you take out a large sum of money, the policy will not last as long as you may need it.
The more you look at universal life the more it looks like a very long term policy. Instead of a 20 year term, you are purchasing a 60 year term or 80 year term. The cash you see will not be there as you get into your older years. I don’t want to guarantee on it but I would bet on it. This doesn’t make them bad but you have to understand how they work and if they fit exactly what you are trying to accomplish.
No one mentioned Indexed Universal Life Insurance. Not nearly as risky as VUL and less expensive to manage, yet IUL are a little more to manage than a Fixed UL. You can have more than one IUL also. Not to mention 401’s, 403’s, IRA’s, Mutual Funds, CD, Annuities, Municipal Bond Funds, etc need to perform on average at 8.25% – 13.5% (depending on which) to match what a IUL can achieve at 7.75% over a 35 year period !! You can get 7% – 8% returns over 20 – 30 yrs on an over-funded IUL, just keep TEFRA, DEFRA and TAMRA in mind. Get the policy for the death benefit you want ($100K, $250K, $500K) and fill the pot quickly, BUT without creating an MEC and let it ride for 30yrs (if you can) and enjoy a $50K+/yr tax-free retirement. And still pass a sizeable death benefit that’s income-tax free to your heirs. Read “Missed Fortune 101” by Douglas R. Andrew, especially the last 3 chapters (10, 11 and 12) !!!
I actuallly have a VUL and I love it. But I do have other retirement accounts. I have plenty of options to choose from for my subaccounts. And so far they have done well. Love the fact that I can increase or decrease my premiums. My policy part of my retirement stratedgy. Similar to a Roth IRA, my withdrawals will be tax-free as I plan to keep the policy enforce. Also, my cost has dropped. Some people don’t realize this but at times your cost of insurance will decrease but so many people are used to buying term with a level premium that the overall cost is priced into the premium.
With that being said, a universal policy may not be the right fit for everyone. As an investment advisor, it’s important to take a look at your entire financial picture before implementing such as policy.
The point of universal life is that it protects people from the ups and downs of the market. If you put your money into an IRA or a 401K and the market goes down, you will loose money. With IUL’s the loss years become a zero return. This means that if you can cut out the losses, the gains are on your base. Nobody ever lost a penny of value in an IUL because the market went down. The worst that could happen is that they get nothing. Which is better, nothing or the 29% loss that the S&P suffered in 2001?
I know this is an old post, but in researching the book that triggered the article, I stumbled across this, I have several problems with this article. I think it’s very clear that the author did not actually read the book while trying to respond to the question, but I understand that the OP never asked anyone else to read it. Regardless, about the reasoning against universal life policies, I’m a little confused.
-Any retirement income you need and withdraw reduces the value of the benefits your heirs will receive, as mentioned above.
This isn’t a negative. If you put money into a UL for the purposes of growing an account and not the death benefit, lessening the death benefit that you weren’t aiming for in the first place is not a loss to you. Any death benefit in the policy would be a BONUS to the person putting money into the UL. For someone putting the money into an IRA, 401k or any other account with special tax treatment, wouldn’t any amount withdrawn and spent not go to any survivors anyways? Calling that a negative is double counting money withdrawn as both spending money and inheritance money, which isn’t true for IRA’s or 401k’s either.
– You’ll be paying much more for less potential performance than other retirement options. Even a 401(k) could cost much less.
Comparing premiums to fees in such a way paints a biased picture. If one should die prematurely, the death benefit that would pass on to survivors could much better leverage the money paid in premiums as opposed to having that money accumulate interest. The risk associated with the death benefit that the insurance company assumes is part of why premiums are more costly than fees charged for investing. A fairer way to present the point might be to say:
“You can pay higher premiums for a death benefit in addition to lower potential and lower risk in a UL (VUL’s wouldn’t fit in this statement anyways) or pay lower fees for a higher potential account with higher risk.”